Commentary and musings on the complex, fascinating and peculiar world that is securities regulation

Saturday, May 05, 2012

Senator Levin Urges SEC to Consider Tax Code Related Commodity Trading in Review of Use of Derivatives by Investment Companies

As
part of the SEC’s broad examination of investment company use of derivatives, Senator
Carl Levin (D-MI) has urged the SEC to review the use of derivatives by some investment
companies to engage in commodity trading through the securities markets in
circumvention of restrictions in the federal tax code and in ways that
eliminate oversight by the CFTC. In a letter to the SEC, he also urged the
Commission to consider how derivative use by some investment companies is
diverting investment dollars away from securities toward commodities,
increasing speculation in the commodity markets, and contributing to greater
commodity price volatility, price distortions, and a weaker economic recovery.
The letter recommended that the SEC work with the CFTC and Internal Revenue
Service to address those concerns.

Right now, said the
Senator, the SEC, IRS, and CFTC all have pending concept releases or policy
reviews that provide a rare opportunity to consider these derivative issues. He
urged the SEC and IRS to use this opportunity to review mutual fund activities,
prevent mutual funds from engaging in large amounts of indirect commodity
investments that the law prohibits them from doing directly, and ensure mutual
funds comply with the 90 percent rule in a way that justifies their continued
tax-exempt status. The SEC and CFTC should acknowledge the widespread use of hybrid
products that combine aspects of securities and commodities trading; consider
joint registration of traders that use U.S. securities to trade in commodities;
and the imposition of increased capital, margin, and liquidity requirements to
protect investors and the markets against risky speculative bets. The SEC and
CFTC should also acknowledge the importance of preventing manipulation and
excessive commodity speculation and use their concept releases to tackle these
problems.

From their
inception, mutual funds were made subject to dual sets of restrictions under
the Investment Company Act and the Internal Revenue Code . Under IRC Section
851, mutual funds have preferential tax status allowing them to avoid payment
of any corporate income tax, so long as they derive at least 90 percent of
their gross income from securities sales, which means that they can derive no
more than 10 percent of their gross income from alternative investments such as
commodities. According to Senator Levin, this tax provision creates a favored tax status
for mutual funds which has enabled the mutual fund industry to avoid payment of
billions of dollars in taxes each year. At the same time, the 90 percent rule
encourages mutual funds to focus their investment dollars on securities,
providing needed capital for corporate expansions and jobs.

In evaluating derivative use by
mutual funds, said the Senator, the SEC should review dollars spent on
derivatives, not only in terms of risk or leverage, but also in terns of
whether they meet the requirements of IRC Section 851(b)(2), which essentially
requires mutual funds to direct the vast majority of their investment dollars
to equities markets, rather than commodity or swap markets. Senator Levin
believes that it is those investments in the real economy that justify the tax
exempt status of mutual funds when it comes to corporate income taxes.

The Senator noted that
an earlier hearing before the Investigations Subcommittee, which he chairs,
exposed how some mutual funds have become significant investors in commodities,
despite the restriction in IRC §851(b)(2).The hearing showed how mutual funds,
which had not historically been involved in commodities markets, began
petitioning for and receiving private letter rulings from the IRS allowing them
to use a variety of tactics to invest in commodities, including through
derivatives. Indeed, he noted that the IRS has issued over 70 private letter
rulings allowing mutual funds to treat income from investments in certain
commodity linked notes or through controlled foreign corporations that invest
in commodities as qualified income under Section 851(b)(2).

These letter rulings
hold that distributions from the commodity linked notes and dividends from the
commodity-related controlled foreign corporations can be treated as income
derived from securities, rather than income derived from commodities, to meet
the income source restrictions in Section 851(b)(2). By treating this income as derived from securities rather than
commodities, said the Senator, the IRS has enabled mutual funds to do
indirectly what they are prohibited by law from doing
directly.

In addition to
allowing mutual funds to use offshore shell entities, the IRS private letter
rulings have permitted mutual funds to use so-called commodity-linked notes to
make investments in commodities. These structured notes can be used, for
example, to create an investment based upon a specified commodity index. The
private letters allow mutual funds to treat these structured notes as securities
investments, despite the fact that the notes are designed and used solely for
the purpose of investing in commodities. Again, a mutual fund's investing in a
structured note in order to make commodity investments that would otherwise be
prohibited by the income source rule is not the type of securities investment
that was contemplated by, or has traditionally qualified under, IRC Section 851(b)(2),
emphasized Senator Levin, nor is it the type of investment that justifies a
mutual fund's lax exempt status. In late 2011, the IRS placed a moratorium on
the issuance of these types of private letter rulings for mutual funds, and is
now conducting a review of the policy considerations.

In addition to
studying mutual funds, the Subcommittee has examined the role of exchange
traded products in US commodity markets, which are a relatively new category of
investment vehicle whose shares arc traded through brokers on stock exchanges,
in the same manner as corporate stocks. They encompass a wide variety of
investment vehicles, including Exchange Traded Funds, which function as
investment companies.

Exchange-traded
products, which continue to evolve in variety and complexity, can be used to
make a wide range of investments, including in securities and commodities. At
first, the SEC approved only those that tracked a specified stock or commodity
index, but in 2008, noted the Senator, the SEC also began approving actively managed exchange traded products
which offer a wide range of investments beyond index products. Commodity-related
exchange traded products, which began appearing in 2004, are a relatively small
subset, but, said the Senator, merit particular attention during the SEC's
review, not only for their heavy use of derivatives, but also for their
potential impact on the US economy.

The Concept Release
currently focuses on derivative use by investment companies, but in his view, derivative use by exchange traded products other than exchange traded funds raise the
same types of issues involving risk, leverage, liquidity, portfolio diversification, and valuation. They also raise
the same types of concerns related to excessive speculation and commodity price
distortions. According to Senator Levin, the Concept Release should not
artificially confine its review to exchange traded funds, but include all types of exchange traded
products, including those involving commodities.

As part of its review
of derivative use by investment companies, the Senator urged the SEC to consult
and coordinate with the CFTC to take a hard look at the securities being used
to invest in commodities, and acknowledge what the market has known for some
time, that commodity related exchange traded products, commodity-linked notes,
and similar financial vehicles are hybrids that combine aspects of security and
commodity instruments. These instruments should be subject to joint SEC·CFTC oversight,
he believes, not only to protect investors, but also to protect commodity and
equity markets from manipulation and excessive speculation that distorts prices
and increases price volatility. Acknowledging these hybrid instruments would
allow both agencies jointly to design appropriate disclosure, regulatory, and
oversight procedures.